I read an astonishing number the other day. $7 billion. Okay, that number in its own right isn’t astonishing, but it becomes so when put in context. That’s the approximate amount that the IRS collected in estimated tax penalties in 2023. That amount was assessed on roughly 14 million taxpayers – all of this according to a recent article in the Wall Street Journal titled “A Surging IRS Penalty is Costing Americans Billions. Here’s How to Avoid it” (6/14/2024). Doubtless, someone reading this post was in that large group. So why such a big amount of money and such a large number affected, and what can you do to avoid getting hit? Let’s explore.
Most Americans pay the majority of their taxes through payroll withholdings. A little bit (okay, a “lotta bit” in many cases) is withheld from each paycheck and remitted to the IRS throughout the year. At “tax time,” your tax return trues up this amount, and you either get a refund (if you paid too much) or you owe (if you paid too little). If your income was steady and your W4 was completed correctly, this amount owed or due is likely relatively nominal. However, a large group of Americans earn money outside of traditional W2 income, all or in part, which means they don’t “enjoy” the convenience of periodic tax withholdings from their income. Instead, they must make quarterly estimated tax payments, so as to remit what’s owed throughout the year. This group includes many investors, retirees, business owners, and gig workers. It can also include more traditional employees, such as those that benefit from stock options.
Figuring out estimated tax payments should, in theory, be relatively straightforward – and the IRS offers “safe harbors” to help taxpayers avoid penalties in many cases. However, as is often the case, it’s never that simple. As such, it’s important to understand the mechanics of all of this so that you don’t find yourself amongst that collection of 14 million taxpayers that were penalized in tax year 2023.
First, the “penalty” is really an interest charge on your underpayment. One reason for the steep climb in total penalties is the recent steep climb in interest rates. The IRS’s formula for the applicable interest rate is the short-term Treasury rate plus three points. It is recalculated quarterly and currently stands near 8%, a big climb from 3% as recently as 2021.
Secondly, we all know that income from sources like investments, retirement distributions, and business distributions can be lumpy. For simplicity, let’s say you have no other taxable income during the year except an $80,000 capital gain in December. An easy assumption to make is that you should then just pay the estimated tax bill resulting from this capital gain by January 15, the next quarterly due date after this gain was realized, and you’ll be good. This is partially true. While you should make that payment by Jan 15, this might not absolve you of an underpayment penalty. How can that be?
This is because the IRS always assumes that your income was earned evenly over the course of the year. So, in their view, you earned $20,000 of capital gains each quarter and should have paid taxes each quarter accordingly. But you didn’t expect this capital gain, so how could you have been that prescient to pay a tax bill eight (8) months earlier (April 15th for Q1 earnings) for income you didn’t see coming? It’s a fair question, and the IRS does provide some relief in the form of the aforementioned “safe harbors.”
These safe harbors, if properly utilized, can completely absolve you of underpayment penalties, even if you underpaid by hundreds of thousands of dollars. So, how does this all work? To best understand this, we’ll borrow from the previously mentioned WSJ article by Laura Saunders, in which she explains some underlying basics.
She explains, taxpayers who owe $1,000 or more normally must pay 90% of their tax bill long before the April 15th annual due date. For employees, the deadline is year-end. For those with other taxable income, the deadline is when fourth-quarter payments are due, which is typically January 15th (visit IRS.gov for complete details on the annual schedule).
If a taxpayer fails to pay the requisite 90%, they need to be protected by a safe harbor in order to avoid an underpayment penalty. Saunders notes, “Making a payment to the IRS at any point can help reduce this interest – so filers potentially facing these unwanted charges can save by making payments before their April 15th due date.”
Let’s now look at how to utilize safe harbors.
- If your AGI (adjusted gross income) is <$150,000, you simply must have paid the IRS 100% of your prior-year tax burden by year end or the January 15th So, here in 2024, if your total tax bill for 2023 was $15,000, if you pay at least $15,000 during 2024, you will be protected by a safe harbor when tax time comes in 2025.
- If your AGI is >$150,000, you must pay 110% of your prior-year tax to qualify. So, here in 2024, if your total tax bill for 2023 was $15,000, if you pay at least $16,500 during 2024, you will be protected by a safe harbor.
Pretty straightforward, but what if you fail to meet the safe harbor requirements and find yourself in a situation where your income all came at year-end, triggering the issue noted above where your payments were sufficient, just not timely? Saunders points out that the way to tackle this dilemma is to file IRS Form 2210 and Schedule AI, which tells the IRS which quarters income was earned and taxes were paid. Your tax professional should be able to guide you through this. If, however, you are a DIY tax filer, you’ll want to check whether your preferred software can handle both forms, as some programs cannot. Saunders also notes that the IRS may not be as heartless as this all makes them sound, as they do often grant waivers for filers “who recently retired after reaching age 62 or became disabled, as well as others who show reasonable cause.” To request a waiver, file an abbreviated Form 2210 using the form’s instructions.
Lastly, there are some forms of estimated payments that the IRS does treat as having come in throughout the year, even if made in a single lump sum at some point during the year. One such payment is a withholding from an IRA. So, if you are a retiree, be sure to utilize the tax withholding option on your IRA distributions in order to help avoid underpayment penalties. Fidelity, like many investment custodians, enables us to withhold at any percentage (in whole numbers), and we can even do a separate withholding journal unrelated to a specific IRA distribution. Note that taxes paid from an IRA do help fulfill your RMD obligations for the year. Withholdings from pensions, Social Security, other pre-tax retirement accounts, and bonuses are also viewed as having come in evenly throughout the year, no matter when they were actually paid.
LET’S WRAP IT UP
I’m always stunned when it takes nearly three pages to explain what should be a relatively simple concept. But I shouldn’t be surprised, as our tax code is many, many more pages in length. Just the instructions for Form 2210 mentioned above are 10 pages of tiny print. That said, I hope you found this helpful as you try to dutifully fulfill your obligations as a taxpayer while also not paying any more than you already have to. As always, we’ll make the requisite disclaimer that we are not tax professionals, and nothing here should be construed as tax advice. Consult with your tax professional for further guidance.